I’m grateful to a reader for sending over some notes he’s made from a psychology of trading book. They’re extremely useful and I’m sure lots of people will benefit from them. So useful in fact that I’d like to have a look at trading psychology in a bit more detail in this article.
Trading psychology is an area that often gets overlooked when people start to trade. The focus is almost entirely on systems then people turn to trading psychology when things go wrong.
The psychology of trading – how to utilise the power of the mind
Pulling the trigger and putting a trade on with real money can be an exciting and agonising decision. Then deciding when to exit can be even more confusing because you might be in a loss-making situation.
Last week I went long the FTSE and so far it’s been a good trade, but I’ve not helped myself with my emotions. Knowing when to enter is one thing, but knowing where to exit and place your stops can be difficult decisions.
Trading can be highly automated with some systems flashing buy and sell signals for you. This should take out all the emotions from your trading, but there’s still so much that our brains can mess up. Unless your trading is completely automated, we still have to pull the trigger and most importantly decide how much money to risk on each trade.
I don’t know anything as damn frustrating, intriguing or rewarding as trading. The ups and downs can be like nothing else. There is immense satisfaction in making money from a trade. It’s like winning in sports – nothing beats the feeling of scoring a goal or finishing the marathon (not done that yet, the hilly New Forest half marathon was enough for me).
Unfortunately the opposite is true; actually, it’s worse. A losing trade hurts like hell sometimes. In fact it’s been psychologically proven that the experience of losing is twice as intensive as the joy of winning.
We’re pre-programmed to hate losing. Unfortunately in the financial markets, this can be a recipe for disaster. Because we hate losing so badly we’ll do anything we can to not realise a loss. This might be the trade that doesn’t go your way so you hold on to it in the hope that it will turn around. You don’t close it early because you don’t want to realise your loss.
Fortunately, there are plenty of books on trading psychology that help point out common mistakes and how to take steps to rectify them.
One of the best trading psychology books available is Trading In The Zone by Mark Douglas. I recommend it to all readers, but if you want a quick summary of some of the key messages, then hopefully the following will be useful.
One of my readers has typed up his notes from the book and sent them over.
TRADING IN THE ZONE
Notes from Trading In The Zone by Mark Douglas:
*You will need to learn how to adjust your attitudes and beliefs about trading in such a way that you can trade without the slightest bit of fear, but at the same time keep a framework in place that does not allow you to become reckless.
*The unlimited characteristics of the trading environment require that we act with some degree of restraint and self-control, at least if we want to create some measure of consistent success.
The hard reality of trading is that, if you want to create consistency, you have to start from the premise that no matter what the outcome, you are completely responsible.
*One of the principal reasons so many successful people have failed miserably at trading is that their success is partly attributable to their superior ability to manipulate and control the social environment, to respond to what they want. (Unfortunately) the market doesn’t respond to control and manipulation (unless you’re a very large trader).
*Successful traders have virtually eliminated the effects of fear and recklessness from their trading. Attitude produces better overall results than analysis or technique.
*The problem is that preventing pain by avoiding losses can’t be done. There is no possible way to avoid losing or being wrong.
*A probabilistic mind-set pertaining to training consists of five fundamental truths:
1. Anything can happen
2. You don’t need to know what is going to happen in order to make money.
3. There is a random distribution between wins and losses for any given set of variables that define an edge.
4. An edge is nothing more than an indication of a higher probability of one thing happening over another.
*Every moment in the market is unique.
*I am a consistent winner because:
1. I objectively identify my edges.
2. I pre-define the risk of every trade.
3. I completely accept the risk or I am willing to let go of the trade.
4. I act on my edges without reservation or hesitation.
5. I pay myself as the market makes money available to me.
6. I continually monitor my susceptibility for making errors.
7. I understand the absolute necessity of these principles of consistent success and, therefore, I never violate them.
*To be an objective observer you have to learn to think from the market’s perspective – every moment is unique.
*You will never know what the market is going to do next.
Take a trip to the doctor…
Psychologist Dr. Brett Steenbarger specialises in coaching traders with their performance issues. He has regular articles on trading and psychology at his blog Trader feed.
It’s highly recommended reading and all free: http://traderfeed.blogspot.com/
There’s plenty of other books I’ve read over the years and found useful. Here’s a quick summary of the best ones on my bookshelf (I am a bit of a self improvement junky):
1. Fooled By Randomness & Black Swans – Nassim Taleb (mentioned 2 weeks ago)
2. Why Smart People Make Big Money Mistakes – Belsky & Gilovich
3. The Psychology of Judgement & Decision-Making – Scott Plous
4. 30 Lies About Money – Peter Koenig
5. Embracing Your Potential – Terry Orlick
6. Against The Gods, The Remarkable Story Of Risk – P. Bernstein.
Amazing trading systems will still give you an edge, but you still have to operate them. Michael Schumacher was an amazing driver because he had one of the best cars AND his mental discipline was second to none. Annoyingly efficient, but a winner.